What are Price Patterns

Price patterns are pictures or formations, which appear on price charts of stocks or commodities, that can be classified into different categories, and that have predictive value.

Two types of patterns

There are two major categories of price patterns–reversal and continuation. Reversal patterns indicates that an important reversal in trend is taking place. On the other hand, the continuation patterns suggest that the market is only pausing for a while, possibly to correct a near term overbought or oversold condition, after which the existing trend will be resumed. The trick is to distinguish between the two types of patterns as early as possible during the formation of the pattern.

The importance of volume

Volume plays an importanct confirming role in all of these price patterns. In times of doubt, a study of the volume pattern accompanying the price data can be the deciding factor as to whether or not the pattern can be trusted.

The preliminary points common to all reversal patterns

1. A prerequisite for any reversal pattern is the existence of a prior trend. Knowing where certain patterns are most apt to occur in the ternd sturcture is one of the key elements in pattern recognition.

2. The first signal of an impending trend reversal is often the breaking of an important trendline. However, the violation of a major trendline does not necessarily signal a trend reversal. What is being signaled is a change in trend. The breaking of a major up trendline might signal the beginning of a sideways price pattern, which later would be identified as either the reversal or consoliation type.

3. The larger the pattern, the greater the subsequent move. The wider the price swings within the pattern and the longer it takes to build, the more important the pattern becomes and the greater the potential for the ensuring price move.

4. Topping patterns are usually shorter in duration and more volatile than bottoms. Tops usually take less time to form. Bottoms usually have smaller price ranges, but take longer to build. For this reason it is usually easier and less costly to identify and trade bottoms than to catch market tops. One consoling factor, which makes the more treacherous topping patterns worthwhile, is that prices tend to decline faster than they go up.

5. Volume is usually more important on the upside. In the early stages of a trend reversal, volume is not as important at market tops. At bottom, However, the volume pick-up is absolutely essential. If the volume pattern does not show a significant increase during the upside price breakout, the entire price pattern should be questioned.